High-yield retakes the stage as messenger of gloom

LauraMandaro

SAN FRANCISCO (MarketWatch) - The high-yield market, which frequently plays the lead in financial disruptions, has been relegated to more of an understudy role during the past months' credit contractions. Now it may be stepping into the spotlight.

Since the start of the year, a stream of dismal indicators about the $1.09 trillion universe of high-yield bonds and their issuers have poured out of investment banks and ratings agencies. Spreads have rapidly widened, returns have tumbled and forecasts call for a jump in defaults such as high-yield issuer Quebecor World Inc.'s (IQW) missed bond payments before it went bankrupt last month.

All point to more concern U.S. companies that issue high-yield bonds, which carry lower credit ratings because the company's debt levels are high or cash flow unsure, will find it harder to make interest payments in coming quarters.

Spreads for high-yield bonds reflected in Merrill Lynch's U.S. High Yield Master II index, one benchmark for the sector, by Monday had jumped to 737 basis points over comparable Treasurys from 592 basis points on Dec. 31. That difference, or spread, represents how much more buyers of those bonds want in interest payments compared to relatively risk-free investments like U.S. government debt.

"What is so remarkable and unique is the speed of this increase," said Margaret Patel, managing director at Wachovia Corp.'s Evergreen Investments and portfolio manager for about $1.4 billion in bond and equity assets. The change in spreads is even more dramatic since June, when they sank as low as 241 basis points, or 2.41 percentage points over Treasurys. Spreads are now well above a historic average of 483 basis points.

This run-up reflects investors' increased worries about the future. "Everyone's risk premium has increased," she said.

Comparisons with past economic cycles suggest the red flags raised by high-yield issuers - whose lower-rated bonds are often termed 'junk' because the issuer has less of a cushion in financial distress -- mean the United States is headed toward recession, if not already in one.

"The last two times spreads got to the present level a recession followed eight months later," said Martin Fridson, CEO of high-yield research service FridsonVision LLC, publisher of Leveraged World, and a former head of high-yield strategy at Merrill Lynch.

On the sidelines

Despite the parallels, the high-yield market isn't carving out the same path it has in past economic cycles. During the tech and telecom bust at the start of the decade, for instance, financially distressed high-yield issuers were part of the first few waves of corporate bankruptcies and stock collapses.

This time, high-yield kept largely to the sidelines as losses unraveled among banks, funds and insurers that had ties, even in an obscure way, to steeper-than-expected mortgage defaults.

"All the financial bad news has only been peripherally involved with high-yield," Evergreen's Patel said.

What's more, spreads are widening even though not that many issuers have reneged on their bonds.

That's a bit of a puzzle, says Fridson. He notes the last time spreads got this wide, the default rate had reached about 4.8%, or nearly 4 percentage points more than today.

One notion for the low default rate is that many issuers are enjoying what's known as "convenant-lite" bank loans, or loans without traditional triggers that make a borrower pay up if its financial condition worsens. These types of loans were made during the liquidity bonanza of the past few years, when companies had their pick of lenders and terms. Loans that lack the traditional covenants may mean some borrowers are staying solvent, longer.

Whatever the reason for low defaults, ratings agencies are now expecting a sharp rise this year.

Defaults to rise

Standard & Poor's forecasts the default rate for speculative-grade credits, or those that carry ratings of BB+ or lower, will rise to 4.6% in the United States in the next 12 months, up from a 25-year low of 0.97% in December and 1.09% in January.

Rival Moody's Investors Service projects defaults to rise even more steeply - to 5.2% for U.S. speculative grade issuers by year-end 2008 from 1% at the end of last year.

That wariness shows up in junk bonds. Returns on Merrill Lynch's benchmark index had fallen 1.4% for the year as of Thursday. That compares to a 1.6% gain for the same period last year. Yields have jumped to 10.11% from 9.67% at the end of the year.

"More and more issues are viewed as being questionable in light of pending debt repayments or the ability to cover interest," said Fridson.

High-yield issuers are feeling the dual pains of a slowing economy and a thinning of investors willing to swap richer yields for higher risk. U.S. gross domestic product slowed to a 0.6% rate in the fourth quarter, down from 4.9% in the third quarter.

Meanwhile, steep losses in collateralized debt obligations, mortgage-backed securities and other sinkholes of the credit market have wiped out some hedge funds and restricted the investment activities of others. Demand from these and other investors flush with cheap credit created by over two years of ultra-low interest rates contributed to the boom in leveraged buyouts, Patel and others say.

There are fewer of these investors now waiting to plough into high-yield bonds. Plus there's a lot of supply: One legacy of the buyout boom is hundreds of billions in related debt that banks would like to sell to investors as loans or convert to bonds. These are competing for dollars with newly issued bonds. Not surprisingly, new issuance has plunged.

"There's a very nervous credit market out there. It's a very poor climate for bringing new deals," said Terrence Dwyer, a senior vice president at high-yield research firm KDP Investment Advisors.

Economic red flags

High spreads and low issuance by the most vulnerable parts of corporate America act a signpost for what's going on in the economy. Problems faced by these companies could also deepen a downturn. Little or more expensive access to credit means some will fail or scale back operations, leading to jobs cuts and reduced business investment.

"You need borrowing spurs for investment," notes John Canavan, an analyst with economic research firm Stone & McCarthy Research Associates.

Tighter credit conditions have already brought down some more strapped companies. Last month, Quebecor and Eagan, Minn. restaurant-chain Buffet Holdings filed for bankruptcy. Montreal-based printer Quebecor failed to get its banks to agree on an 11th hour bail-out package, while restaurant chain Buffet blamed a sharp drop in consumer spending.

The market has reacted swiftly to the potential for more defaults. Distressed issues, or those trading more than 1,000 basis points over Treasurys, made up 17% of the bonds in the Merrill Lynch high-yield index at the end of January, up from 1% in June.

"There is definitely a lot out there which suggests distressed companies are having trouble," said KDP's Dwyer.

Not surprisingly, the issuers with the worse credit ratings have been knocked the hardest in the market. Rexnord Corp., a precision-parts maker, saw its bonds with Caa1/CCC+ ratings sell off 13.5 percent points in the month through Jan. 25.

"We're seeing a lot of pressure year-to-date on CCC credits," or bonds at the low-end of the junk scale, Dwyer said. "They're certainly taking it on the chin."

At the same time, spreads on leveraged bank loans have widened even further than comparable bond debt. That difference is making it more enticing for institutional investors to buy loans with the same characteristics as bonds, a further blow to the high-yield market.

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